Notes From a Native Son – the NIS: Who Is Killing The Goose That Lays The Golden Egg?
According to some reports, the governor of the central bank expressed amazement when a leading credit rating agency reduced the Barbados credit rating to junk status. I am not sure if he was surprised that the agency had the audacity to downgrade Barbados, or that it took them so long to realise that the nation’s economy is insolvent. This aside, there is everything wrong about the governor’s publicly expressed views, given he is by office the senior financial regulator, and what these observations say about his understanding of the importance of monetary policy and of the important role banks play in society.
To deal with just one aspect: he is on record as giving his backing, somewhat surprisingly, for Canadian banks based in Barbados on the basis of their efficiency. Although this may be true, there is a fundamental difference between the regulation of a bank branch and a subsidiary, between the controls exercised by the host jurisdiction and the home jurisdiction, and generally in cross-border banking. And, more so, the importance this structure plays in financial intermediation and the control of M1 money in the economy and the funding of small and medium enterprises and mortgage borrowers. In other words, the economy can be held to ransom by banks that listen to orders from their head offices based in Hamilton, Port of Spain or Toronto, while ignoring the pressing needs of the Barbados economy. Further, some of these banks expatriate money to their home bases at the end of business every working day. This is a key part of the capital flight that is really damaging to the economy.
But let us concentrate on the national insurance scheme, its use as a piggy bank by the government and its longer term obligations. In a properly managed scheme, the only obligations the fund has is to existing and future beneficiaries, and to meet these long-term commitments the scheme devises an investment strategy as its main strategic tool.
Investments are highly technical and should be managed by professional experts, not by civil servants or politicians. So, based on the number of retirees each year for the next thirty or forty years and therefore the fund’s long-term obligations, the investment strategy should be structured to meet these commitments without threat of insolvency or default. For example, if the actuary, through his/her complex mathematics has decided that a given number of future beneficiaries will retire over the coming years, they secure this future outlay by investing in fixed income – either government or corporate bonds, preferably over a number of different markets. This is to diversify the investments so that if one jurisdiction runs in to trouble the ‘safe haven’ will balance it out.
The others parts of the investment strategy are investing in equities (or shares) to provide growth or income through dividends, but the risk of this is greater than bonds so there must be caution. Investments are often also made in property, again to diversify the portfolio, and some money is kept in cash. This used to be for rainy day purposes, but cash has now become in the post banking crisis years an asset class. Some adventurous pension fund managers also invest in what is called alternative investments, which bring in greater returns than ordinary bonds or equities. The reason for this is that there are high-risk and the investor can lose his or her money on the investment. This is the basis of modern portfolio theory, that diversification increases risk-adjusted returns.
So, to explain in simple terms, an average pension investment manager may decide to put forty per cent of the fund in bonds, twenty-five per cent in equities, fifteen per cent in property a further fifteen per cent in cash and the remaining five per cent in alternative investments, mainly hedge funds and private equity. Having made that decision, asset allocation as it is called technically, a decision must now be made on stock picking, again a job for the experts. Because the investment board has decided it would invest twenty-five per cent of its money in equities, it now has to decide the strategy for investing that money.
It may decide, for example, to emphasise geographical investments, and plump to invest fifty per cent of that twenty-five per cent in Barbados and the wider Caricom region, a further thirty per cent in the US because US markets are still giving the best returns in the world, fifteen per cent in emerging markets, because these are the fastest growing markets, and five per cent to fund venture capital projects, mainly in Barbados. This breakdown only goes part of the way, the big decision, which is more technical than it seems, is to pick the actual companies – stock picking.
Or, on the other hand, the investment committee may go for a thematic investment policy: investing in energy, banks, tobacco, travel and leisure, etc.
Politics and the NIS:
We do not have to get in to actuarial complexity to understand the degree of abuse of the fund by this and previous governments. All we need is to remind ourselves that the purpose of a pension fund is to provide an income for the beneficiary in retirement. So, people contribute during their active working lives and draw down on the fund on retirement with the state setting the state retirement age based on average longevity.
In most societies, the state pension scheme is what is a pay-as-you-go scheme, that means the current generation of workers’ contributions go towards providing an income (a pension) for the retired. But the Barbados NIS scheme is a hybrid scheme, apart from the contributions from those in work, there is also a huge investment pot from which dividends are earned which go towards building up the reserves of the scheme.
A pension scheme, particularly in this global economic climate, should be cautious and aim for Beta returns rather than become over-ambitious and aim for actively managed mandates with the promise of Alpha returns, or outperforming the benchmark. Charges are higher, transactions drive up costs, and any Alpha returns are some how dissipated through high charges. Despite the marketing boasts, few active managers have the skills and knowledge to make consistent Alpha returns. If they did, they would be working for themselves making billions of dollars, rather than for clients. There is no magic and, as the Chicago School has shown, a lot of it is luck. The alternative to an actively managed fund is a passive fund, once that tracks a benchmark for example the S&P 500 or the FTSE 250; the charges are transparent and lower because there will be no trading costs or stamp duty to pay, and bi-annual or annual rebalancing of the portfolio can make a bigger difference than it does with actively managed funds.
The risks to the NIS are numerous, but the most immediate one is political interference in the management of the fund and politicians dipping their hands in the pot. This should be restricted by legislation. The other risk is that of high unemployment: the higher the unemployment rate the lower the contributions (and the greater the benefits that have to be paid out for some of the scheme’s other responsibilities. But that is another matter). The other major risks are those of having three active funds managed by US-based fund managers, which is a waste of money, and finally, as we have already seen by the government, changes in legislation that reduces the level of income.
Analysis and Conclusion:
One thing I find really disappointing is that as a nation we have spent over 45 years fooling ourselves of how great we are, convincing ourselves of our own invincibility, of being better at exceptionalism than even the Americans, which is saying something. In the meantime, we have missed one or two good tricks: like how to make a small island people very progressive, not only in a material sense, but collectively socially and culturally.
In a transparent and open system, the NIS should have up–to-date details on its investment strategy on its website, its asset allocation model, risk profiles of all investments and the latest triennial actuarial reports. It should make public its long-term liabilities, including the number of beneficiaries and, over and above the actuarial reports, projected demographic changes. The one thing that should be absent from this entire process should be the involvement of general civil servants and politicians. Civil servants are administrators and should be restricted to managing the back office processes such as updating records, sending out reminders, making sure people receive their benefits on time, etc. Politicians should be restricted to setting the broad framework for the scheme, but not in deciding policy or even, heavens forbid, dipping their hands in the pot when they see fit. The people running any national insurance scheme should be professional actuaries and fund managers and they should do so in the sole interest of beneficiaries. If the national insurance scheme is not living up to these principles then it is failing the nation and its members.
It is a noble policy objective to use the pensions contributions of Barbadian workers to create new jobs for future generations of Barbadians. It is in the interest of beneficiaries. However, in meeting this objective the scheme and government should not put at risk the entire risk the financial viability of the entire fund. In the final analysis, however, we need professional people with the right experience and knowledge running the NIS scheme and not academics or over-ambitious, crowd-pleasing politicians.
In any case, the model is flawed. What we need is a new kind of national pensions, but that is another debate. By the way, one contribution that students at the UWI Business School can make to the NIS as an academic exercise is to carry out the risk-profiling and market risk analysis for the fund as part of their learning process. In that way they will be making an invaluable contribution to local understanding of how equity and bond markets work.